Deflation: a decrease in the general price level of goods and services of an economy. Sounds great, right? Lower prices mean the purchasing power of our income increases, making the “average” person richer! On the surface, it could be concluded that deflation may actually be a good thing. And in some cases, it is!

If prices of goods are falling because of major technological advances (think of the price of cell phones and laptop computers over the last 20 years) or because of massive improvements in the productivity of labor and capital (think of the price of manufactured consumer goods during the Industrial Revolution), then deflation could be considered a sign of healthy economic growth. Put in terms an IB or AP Economics student should understand, a fall in prices caused by an increase in a nation’s aggregate supply is good, since it is accompanied by greater levels of employment and higher real incomes. But if the fall in prices is caused by a decline in spending in the economy (in other words, by a decrease in aggregate demand), the consequences can be catastrophic.

It just so happens that the United States, Great Britain, and my own home of Switzerland are all faced with demand-deficient deflation at this very moment. I’ll allow the Economist to elaborate:

…With unemployment nearing 9% (in the United States), economic output is further below the economy’s potential than at any time since 1982. This gap is likely to widen. House prices are not part of America’s inflation index but their decline is forcing households to reduce debt , which could subdue economic growth for years. As workers compete for scarce jobs and firms underbid each other for sales, wages and prices will come under pressure.

So far, expectations of inflation remain stable: that sentiment is itself a welcome bulwark against deflation. But pay freezes and wage cuts may soon change people’s minds. In one poll, more than a third of respondents said they or someone in their household had suffered a cut in pay or hours…

Does this matter? If prices are falling because of advancing productivity, as at the end of the 19th century, it is a sign of progress, not economic collapse. Today, though, deflation is more likely to resemble the malign 1930s sort than that earlier benign variety, because demand is weak and households and firms are burdened by debt. In deflation the nominal value of debts remains fixed even as nominal wages, prices and profits fall. Real debt burdens therefore rise, causing borrowers to cut spending to service their debts or to default. That undermines the financial system and deepens the recession.

From 1929 to 1933 prices fell by 27%. This time central banks are on the case. In America, Britain, Japan and Switzerland they have pushed short-term interest rates to, or close to, zero…

…inflation is easier to put right than deflation. A central bank can raise interest rates as high as it wants to suppress inflation, but it cannot cut nominal rates below zero… In the worst case, rising debts and defaults depress growth, poisoning the economy by deepening deflation and pressing real interest rates higher….Given the choice, erring on the side of inflation would be less catastrophic than erring on the side of deflation.

Discussion Questions:

Deflation poses several threats to an economy that is otherwise fundamentally healthy, such as the United States’. What are some the threats posed by deflation?

The expectation of future deflation can have as equally devastating effect. Why is this?

What evidence does the article put forth that an economy experiencing deflation may eventually “self-correct”, meaning return to the full employment level of output in the long-run?

Why don’t governments and central banks just sit back and let the economy self-correct? In other words, why are fiscal and monetary policies being used so aggressively by the US, Great Britain and Switzerland during this economic crisis?

Deflation or Inflation:Watch the video below, see if gives you any clues as to the causes and effects of deflation. What do you think John Maynard Keynes would say in response to the deflationary fears expressed in the Economist article?

About the author: Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course.
Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

1.Deflation poses several threats to an economy that is otherwise fundamentally healthy, such as the United States’. What are some the threats posed by deflation?

2.The expectation of future deflation can have as equally devastating effect. Why is this?

3.What evidence does the article put forth that an economy experiencing deflation may eventually “self-correct”, meaning return to the full employment level of output in the long-run?

4.Why don’t governments and central banks just sit back and let the economy self-correct? In other words, why are fiscal and monetary policies being used so aggressively by the US, Great Britain and Switzerland during this economic crisis?

Deflation, or falling prices, cause the revenues of companies to decrease. This means that they must cut costs, which results in more unemployment. If less people are employed, then there are less people with disposable income to spend on goods, and demand drops even further, causing the price level to drop even more.

Deflation poses several threats to an economy that is otherwise fundamentally healthy, such as the United States’. What are some the threats posed by deflation?

Unemployment is the biggest threat. When deflation occurs due to a declining aggregate demand profit maximizing firms will fire many people since they will not produce as much as before just like they are not earning as much. GDP has gone down. Jobs will therefore get scarcer and scarcer and wages will be lower.

Also, since the nominal value of debts remains during deflation the actual real debt burdens increase, which will mean that people will cut spending and focus on saving to make up for the debts which will decrease aggregate demand even more.

The expectation of future deflation can have as equally devastating effect. Why is this?

If people expect future deflation then they will not spend now but save the money since they expect their purchasing power to rise. This means that due to these future expectancies the aggregate demand will shrink, leading to a decrease in national income.

What evidence does the article put forth that an economy experiencing deflation may eventually “self-correct”, meaning return to the full employment level of output in the long-run?

The article states that people will “cut spending” which will mean they will save more. Firms have access to this saving and therefore will this money to increase their stock of capital and their output, which will increase the national income again.

Why don’t governments and central banks just sit back and let the economy self-correct? In other words, why are fiscal and monetary policies being used so aggressively by the US, Great Britain and Switzerland during this economic crisis?

Self correction takes a long time. Governments want to make people happy and are in pressure to ensure good living conditions if they want to be revoted. If a government waits for the situation to better people, who live in misery will revolt against it and demand a leftwing change, where government is intervening with the economic structure.

Deflation seems like a good thing, because it means that our money becomes more valuable which causes low prices. Companies, however, experience a decrease in their revenues so that they have to lay off workers as they have to cut costs. As unemployment rises, there are less and less people with disposable income to spend and accompanied with the fact that investment made by firms fall, this leads to a decrease in aggregate demand which is witnessed by even lower prices and a decrease in a nation's real output.

The expectation of future deflation also causes people to save money and spend less. This is a reaction to the fear that their real spending power will decrease. Demand will fall again causing the prices to fall even lower. However, the expectations for inflation seem to be that it will remain stable. This implys that the economy could self correct since americans are confident in the value of their money. Monetary policy is very important in the short run. Though in the long run the economies will self correct, it could take many generations untill the economy recovers again. Since we cannot wait that long, our govenrments need to intervene. Sitting back and watching millions go unemployed and struggle is not the way our western society functions. Those with savings and real estate will be fine, since the prices will go down and they will still have money, yet the poor will get poorer as their income dissapears. The gap between the rich and poor will widen, and one of the goals of governments is wealth distribution.

Even though deflation can sound like a good thing for consumers because of low prices, it can also have devastating consequences. One of the main threats posed by deflation is unemployment. Since the price level drops, people can buy the same products for less, meaning that they have a greater real income. However this has the opposite effect on firms. Lower prices means that they now sell the same products for less, experiencing a decrease in revenue. This caused companies to lay off workers in order to decrease costs. This leads to unemployment.

The expectation of future deflation can have a very harmful effect on the economy. Because people know that they will be experiencing deflation in the future, they will start saving money instead of saving it. This will cause a decrease in consumption. Because of the fact they expect deflation, their confidence will also fall, which will lead to an ever bigger decrease in consumption and therefore a decrease in aggregare demand. The fall in demand then causes a decrease in output and a decrease in price level, leading to deflation.

Govenments don't wait for the economy to self-correct because this would take a long time, this can only happen in the long run. The huge fiscal stimulus are implemented because people are not willing to accept lower wages at the time. The short run is also called the sticky wages period, meaning that firms cannot decrease wages in such a short time limit. For the economy to self-correct people would have to accept lower income and therefore less spending.

Due to deflation, the price level decreases. To adjust for this the firms have to cut wages or lay of workers because they aren't able to pay these wages anymore due to less revenue. Therefore unemployment increases.

When people think that there is deflation coming than they will save their money to spend it during the time of the deflation because it seems cheaper for them. But if they don't spend than the real GDP will decrease because less is consumed and invested.

What evidence does the article put forth that an economy experiencing deflation may eventually “self-correct”, meaning return to the full employment level of output in the long-run?

It takes a long time for an economy to self-correct, that's why the governments have to intervene. Government spending must increase so that the economy goes back to full employment. In the short run the firms cannot cut taxes but in the future they can adjust to the deflation by decreasing taxes.

If an economy experiences deflation it is almost worse than when it experiences inflation. During deflation prices fall, which does not sound bad to a consumer at first, but once prices start to fall companies output decreases which forces them to lay of workers because they have less profits. This creates increased unemployment, which has a very negative effect on the economy.

The expectation of deflation can have a negative effect on the economy because people will start saving their money. They will save their money instead of spending it, which could cause the economy to slow down. This would decrease output and could cause higher unemployment.

Why don’t governments and central banks just sit back and let the economy self-correct? In other words, why are fiscal and monetary policies being used so aggressively by the US, Great Britain and Switzerland during this economic crisis?

Fiscal policies are very popular during times of recession, because most people are not confident that the economy will self correct itself. In addition to that an economy in a recession could takes a very long time to self-correct itself which is not always an option for some companies. The fiscal stimulus package is more predictable and gives the governments more confidence, which will increase consumers confidence.

The falling prices in the house market is forcing households to reduce their debt, thus freezing much consumer spending in the economy. The problem is that as the NOMINAL wages, profits and prices fall, the nominal value of the debt remains the same, meaning that the REAL value of debt increases as it takes deflation into account.

Deflation means a decline in price level and an increase in purchasing power, so people will want to save more in the present and spend more in the future when the prices of goods and services are expected to decrease.

The government could sit back and watch the economy slowly correct itself but who knows how long this could take? Politics play a role in that whichever party is in power will want to do anything possible to assure the economy runs smoothly during their time in order to appeal to the public and maybe get reelected. And if everyone is better off when the economy is healthy (less unemployment, more productivity…etc) then why not do anything possible to assure that?

1) If deflation is caused by a decrease in the aggregate demand curve then it can be threatening to an economy, such as the US's right now, in that the nominal value of goods, services, wages and prices are decreasing while the debts of households and firms remain the same. Once deflation is taken into account, real debt is now greater and households/firms are forced to save up in order to be able to pay for these debts. An economy where people are not spending further worsens it.

2) When people expect there to be deflation they save up because they will use these savings in the future when prices decrease. This deflation is caused by a decrease in aggregate demand, as opposed to an increase in supply, which is the worse of the two kinds. A decrease in aggregate demand means a decrease in the value of prices, wages and goods as well as a decrease in employment and income. This is all a result from what the population expects rather than what would have happened if they hadn't expected anything.

Deflation doesn't have to be a bad thing at all. The issue is that people don't realize that if they are flexible with their wages, the price level will adjust to bring things back to normal, even if everything seems worse, you will be equally as wealthy. Because people don't understand they shun deflation like the plague, and consumer confidence, necessary to run a healthy economy, falls dramatically. That is why deflation is really so destructive.

Governments attack recession with their fiscal policies with such vigour because of the immediate benefits. Because they won't profit as much from a long run correction, (they might be out of office, or have their term ended), they decide that a short term correction policy will be of more use. To combat recession, they send government spending into overdrive and tweak interest rates for the "better".

1. Deflation means that the value of money increases. This means that firms make smaller profits because people can buy more ‘stuff’ for less money. (Assuming people aren’t too afraid of the future and save more money than before) Firms now have to lay off workers to decrease their production costs. More unemployment leads to less consumption which decreases AD.

2. People will save more when they expect their spending power to decrease in the future. Less demand forces firms to decrease prices and therefore lay off workers and so forth, the cycle starts again. As we learned in class today, big C (consumption) is not nearly as important as GIANT C (confidence).

4. Because they are Keynesians. The classic view on this topic is that an economy will self-correct. The governments know that people don’t want to earn less and therefore spend less. In a recession that is unavoidable. But you can let the economy self-correct over a very long period of time, or help the economy with stimulus packages and ‘get it over with’ as fast as possible.

1. Deflation poses several threats to an economy that is otherwise fundamentally healthy, such as the United States’. What are some the threats posed by deflation?

Deflation can be good in how it lowers prices and hence making people richer. This however does pose a threat. For example a decrease in aggregate demand, which is what the US is experiencing, leads to a decrease in revenue for firms and as a result they have to cut costs and the only way to do that in the short run is to lay off workers, hence increasing unemployment.

2. The expectation of future deflation can have as equally devastating effect. Why is this?

Since people know that prices will become even lower than they are now, they logically save money so that it can buy them more in the future. This may be good for the individual consumer yet for the economy as a whole this is bad because it leads to less consumption which means less aggregate demand which means a low national income.

To the average consumer and to someone who has not studied economics, deflation sounds 100 times better then inflation. Deflation basically means you get more for your money, but for companies and the economy this is extremely bad. As deflation happens companies experience a decrease in revenues meaning to sustain themselves and reduce costs they will lay off workers. There is now an increase in unemployment, means less households have disposable income to spend on goods and services, investments will fall as well due to the need to cut costs, firms will no longer be buying new machinery and this in turn results in a decrease in aggregate demand and results in lower prices (forcing the events to happen again and again) aswell as a decrease in the nation's output. And causes GDP to fall.

The expectation of deflation can have just as much effect as deflation as itself because people will start to save money, meaning their is a leakage to the natural flow. Households will see it as, if i save $5 today then next year due to deflation with that $5 i wil be able to buy the equilavent of $10 of stuff. This leakage caused by households will result in the above sequence of events.

Like everyone said, deflation often means doom. Deflation reduces revenues for firms who then are obliged to lay off workers. These workers then experience a decrease in their real income and their consumption will reduce hence AD as well as GDP will decrease even more. But this is the "bad" deflation meaning the deflation that occurs when there is a decrease in AD. One mustn't forget that there is also a "good" deflation that occurs when there is an increase in SRAS. In such a situation, the deflation happens because of reasons such as improvements in technology, or better education or better infrastructure which improves productivity. Accompanied is also a decrease in unemployment and an increase in real output.

Demand pull deflation will cause the equilibrium point to move left along the SRAS curve, causing unemployment to rise, which in turn will reduce consumer spending, moving the equilibrium point further left. This cycle could continue indefinitely.

The expectation of future deflation can cause people to become insecure about their job, and will therefore reduce consumption and then start the demand pull deflation.

Governments don't let the economy self correctly because no-body is sure how long the LRAS supply curve will take to take effect. It could be a couple of months where government policy is less needed, but it could be a decade, which is a long time for people to be in poverty. Also, government wants to be re-elected. That won't happen if the people think that they didn't do anything to improve the economic situation.

Deflation may sound good to an individual, as prices decreases and a household may benefit. However, firms will not get as much revenue, because the prices have fallen. Because of this, firms have to lower costs which leads to job cuts and people being layed off. Deflation also increases unemployment, due to firms cutting costs and having to lay off workers.

If people expect ‘future deflation’, they will have a tendency to save their money rather than spend it. This could have devastating effects on the economy because less money will be put into the circular flow, and the money that is saved up will not be counted in a nation’s GDP. Because households will start saving, there will be a decrease in consumption, which will shift the aggregate demand curve. Due to this, there will be a decrease in output and firms will have to lay off workers to cut costs.

Because self correction takes a long time, it is important for a government to step in and make changes right away. Government spending will boost the confidence of the households which could then lead to recovery, and full employment. People are not sure that the economy will correct itself and are often not able to see itself correct. A stimulus package is a solution that has effects which are seen right away. Political parties also want to be re-elected, which is why they take action right away and promise to change the economy by increasing government spending.

Deflation makes firms revenues lower. It forces them to cut costs, which means they must lay off more workers. The more workers they lay off the less disposable income there is in the circular flow. This means demand will drop because no one has money to buy anything with, soon the price level will drop and firms will slow down supply so that they can get rid of their inventories.

1. Deflation will make people more cautious with their spending since they will most likely be able to spend less on more in a year, these causes a slowdown int he economy as people no longer want to put their money in investments and the multiplier effects severely decreases.

2. The expectation of future deflation is equally as devastating because in anticipation, people will hold on to their money to begin with causing for sure a recession or deflation.

1.) Deflation is extremely bad for the economy as a whole as it decreases the revenues of firms, making them cut more costs, usually decreasing it’s work force which increases cyclical unemployment.

2.) Bad expectations of the future are bad for all cases in an economy. With deflation, just like you wait to get an iPod because you know a newer one will come out soon, people save their money, for when the prices are lower. If products are not being sold, firms decrease prices and lay off workers, causing the expected deflation.

3.) The article mentions that the cutting of interest rates may slow down or save an economy from deflation, as it will get firms to invest. The only problem is that at a certain point the interest rate reaches zero, and deflation can’t be prevented.

4.) The classical theory of letting the economy self correct does work, but it may take time and conflicts to self correct. Therefore, if it can be corrected in the short term by government regulation, it is more beneficial.

4. Why don’t governments and central banks just sit back and let the economy self-correct? In other words, why are fiscal and monetary policies being used so aggressively by the US, Great Britain and Switzerland during this economic crisis?

1) Although on a personal level deflation may seem beneficial, on the macro economic level it is very dangerous. Firms will lose revenues, which is the initial step in a downward cycle that leads to them cutting costs to cover for the decreasing revenue which means that more people have less money to spend which leads to further cost cutting and so on.

2) If deflation is expected in the near future then consumers who would normally consume would rather save their money for the rainy day approaching, by doing this they are effectively doing the same as they will have in Question 1, which leads to the same downward spiral.

3) Although the economy will self-correct itself, this only happens in the long-run, which can be anywhere from months to decades, and that's the problem, no one knows when the self-correct will actually kick in, so Governments can't afford to wait this long, and thus they must take action in a shorter period of time.

At first, deflation is seemingly a good thing for the consumer, as it increases his purchasing power. However if the deflation persists it results in firms earning lower revenues, thus the firms will have to start lay off workers. Then, as more and more people become unemployed there will be less AD, since there will be less disposable income for them to spend, which will ultimately result in a downwards spiral.

Deflation poses several threats to an economy that is otherwise fundamentally healthy, such as the United States’. What are some of the threats posed by deflation?

Deflation can be a well quality in lowering prices and therefore makes people wealthier. Deflation means as a persistent decreases in the price level or more loosely as a situation in which output and employment are falling as a result of a fall in aggregate demand. This means that firms make smaller profits because people can buy more needs for less money. Thus, due to firms that have to lay off workers to decrease their production costs, more unemployment leads to less consumption which decreases aggregate demand.

The expectation of future deflation can have an equally devastating effect. Why is this?

As long as any people in the world are aware of the money, they save money so that they can buy more goods and stuffs they might need in the future. This is a big benefit for the individual consumer though yet for the economy as a whole, it is not very good because it leads to less consumption which means less aggregate demand, again this means, a low national income.

What evidence does the article put forth that an economy experiencing deflation may eventually “self-correct”, meaning return to the full employment level of output in the long-run?

The article states that the “cutting of interest rate” could decelerate or save an economy from decrease in prices, as it will get firms to invest. The difficulty is that, the interest rate reaches to zero, and deflation cannot be prevented though the economy will self-correct itself. This only happens in the long run, which can be wherever from months to decades. No one knows when the self correct will actually break down, therefore, governments cannot afford to wait this long, and thus they must take action in a shorter period of time. Thus, this will increase the national income again.

Why don’t governments and central banks just sit back and let the economy self-correct? In other words, why are fiscal and monetary policies being used so aggressively by the US, Great Britain and Switzerland during this economic crisis?

This is because self-correction takes a long time. Governments always try hard to provide goods as much as possible within good qualities and so they know that people could ensure good living conditions if the government want to be re-elected. On the other hand, some governments know that some people do not want to use all the money they have but instead prefer to save them for future. But the economy can be self-corrected over a very long period of time. In this kinds of ways, the classical theory of letting the economy self-correct might work, but it may take time and conflicts to self correct. Therefore if it can be corrected in the short term by government, it is more beneficial.

It was nice to read your answer! And now, I would like to comment about your responds =D

First of all, there were four questions given, but it seems to me that you only answered 3 questions. Also, when I was reading your answer through it, I found in your second paragraph that said ‘Because people know that they will be experiencing deflation in the future, they will start saving money instead of saving it.’ I do not get this part. I think you made a mistake, or you might want to say: “they will start saving money instead of spending them at ones.” All of these, however, I agree with most of all your answers especially where you stated that ‘the short run is called sticky wages period. As most of people think that it is important that economy to self-correct people would have to accept lower income and therefore less spending, I think so too and it is actually true story which might lead our life to an easier way.

1. Deflation poses several threats to an economy that is otherwise fundamentally healthy, such as the United States’. What are some the threats posed by deflation?

~Threats that are posed by deflation are wages and prices will come under pressure. Wages will be cut as well as working hours; this will greatly decrease income in a household. Also, debt will be of an a nuisance and increase.

2. The expectation of future deflation can have as equally devastating effect. Why is this?

~Future deflation can be as equally devastating because money will have a greater value so there would be no reason to invest in anything else.

3. What evidence does the article put forth that an economy experiencing deflation may eventually “self-correct”, meaning return to the full employment level of output in the long-run?

~This Neo-Classical idea is presented because it says that the people will eventually “cut- spending” so that they save more of their money instead of buying more, all on their own. The stocks and businesses that will accredit the money will use it to increase output to eventually raise national income.

4. Why don’t governments and central banks just sit back and let the economy self-correct? In other words, why are fiscal and monetary policies being used so aggressively by the US, Great Britain and Switzerland during this economic crisis?

~Instead of just waiting for the economy to self-correct economists and the government step in so that the national income will rise more quickly and to be more sure that the possibility of it correcting is more evident.

1. One threat that deflation might cause is a fall in price of goods and wages. In addition working hours are most likely to fall so therefore people will earn less and people will need more money and debt will rise.

2. A future deflation might be catastrophique because people will keep the same living habits, but they will not have the same financial possibilities. So they will get into more debt and the cycle will get worse and worse.

3. It might self-correct itself if the intrerest rates are lowered so that investment is encouraged but if they are at 0% and the deflation still continues there is not much you can do.

4. They dont sit back and wait until the economy self-corrects itself because it will take much too long so they rather act and do something to fasten the processs of self-correction.

I agree for your answers 1,3 and 4 but for the 2 question, why would there not be a reason to invest if the value of money has risen. It should not matter because the prices would be less but the value the same

Deflation poses some threats to an economy that would otherwise be considered fundamentally healthy. Deflation causes prices to fall, mainly because of an increase in a nation’s aggregate supply. This outcome is accompanied by greater levels of employment as well as higher real incomes. All seemingly beneficial to an economy, however when in conjunction with a decline in spending, deflation becomes catastrophic and spreads the economy thin. As in deflation, when prices are decreased due to a decline in consumer spending in the economy and a decrease in aggregate demand, what once was a good thing, a fall in prices, becomes disastrous and a downward spiral occurs.

The expectation of future deflation has equally devastating effects, as wages and prices come under pressure. If people are expecting the economy to deepen and the gap to widen, then more and more people will be competing for scarce jobs and firms will be underbidding each other for sales, forces wages as well as prices to compete and fold under the pressure generated by the failing economy. This behavior begins the deflationary issues as the economy starts to drop.

An economy experiencing deflation may eventually “self-correct”, increasing the employment rate as well as the level of long-run output. This happens because as the level of consumer prices decreases, aggregate supply is increased and the economy then requires a greater rate of employment to compete with the increased aggregate supply. With more employment, real income levels increase and through these factors, an economy may auto correct.

Although an economy maybe be able to fix itself, governments and central banks choose to intervene and institute fiscal and monetary policies to aide in the solution process because even though the economy has a chance of fixing itself if consumer prices fell due to an increase in aggregate supply, when consumer prices are falling due to a decrease in aggregate demand and consumer spending, deflationary conditions are catastrophic and if there is no intervention then the economy has no chance of recovery.

I think it's interesting to consider why governments intervene in terms of their own political agendas, that's a new perspective I hadn't considered. However, I do think that it isn't the only reason governments and economists try to fix a failing economy, as a failing economy is detrimental to everybody and I'm sure that they have other agendas, besides wanting to win the next election.

If the cause of the falling prices is caused because of a decrease in aggregate demand, there can be many bad effects. Some of the threats that are posed by deflation include the decrease in wages, or real debt burdens rise. If prices fall then the wages could fall to because of the decrease in demand for the goods. Or if the real debt burdens rise, this is because the people that are borrowing will cut their spending in order to keep paying their debt.

2.

This is because the value of the money will decrease and if people are expecting or aware of this fact, then the aggregate demand will decrease and also investments.

3.

Because banks have the capabilities to manipulate the interest rates when deflation or inflation is occurring, in the short term as the deflation is occurring, the employment level might fall however as the interest rates are lowered, and spending increases, the full employment level could be restored as prices start to rise again and employment picks up.

4.

If the governments sit back, and don’t implement their fiscal and monetary policies, then the spending of the people might not increase because they just want to keep their money in the bank and save it. That’s why countries such as the US, G.B, and Switzerland are so aggressively pushing these policies, to help get their country out of deflation.

I wrote something different from you in my answer to #2. I wrote that the value of the money will decrease instead of increase (what you wrote). I think that with the price levels going down, the value for all the goods and services will also decrease and so the value of the money will lessen.

I'm not sure which of our answers is correct..!? But maybe someone can share their input.

1) Deflation poses several threats to an economy that is otherwise fundamentally healthy, such as the United States’. What are some of the threats posed by deflation?

Deflation can lead to unemployment, as companies cut costs to maximize profits. Also, the real value of debt increases as money is worth less for paying it off.

2) The expectation of future deflation can have an equally devastating effect. Why is this?

Aggregate demand will fall even more, as consumers wait for the lowest possible prices.

3) What evidence does the article put forth that an economy experiencing deflation may eventually “self-correct”, meaning return to the full employment level of output in the long-run?

The companies will eventually save enough money to hire more workers and make more products, thus giving consumers more to buy.

4) Why don’t governments and central banks just sit back and let the economy self-correct? In other words, why are fiscal and monetary policies being used so aggressively by the US, Great Britain and Switzerland during this economic crisis?

Self-correction takes far too long to work, which angers voters and removes that government from power. However, if they step in and solve the problem, they can pacify voters and get re-elected.

1. Deflation in an economy would likely cause a fall in the price of goods, due to the fall in aggregate demand.

2. A threat of future deflation would cause some people who might spend rather then save actually save their money. This would start a cycle of debt that just gets worse and worse.

3. The economy will eventually correct itself, but this can take time. If the incentive to invest is increased, this can help. However, that job is usually taken on by the government, and if its a capitalist economy, this could cause problems.

4. If governments just sat back and didn't do anything for the economy, it might get way worse before it gets better. If the government can intervene and hasten the process of economic recovery, then the sooner the better.

The process of self-recovery does take longer then if the government were to step in, but there are those who firmly believe, like Adam Smith, that the government should not play a role in the economy under any circumstances. Although you make a good point about how the politicians need to get re-elected to make their policies work. So even in a capitalist economy, the government needs to step in for practical reasons as well as financial reasons.

1. Deflation poses several threats to an economy that is otherwise fundamentally healthy, such as the United States’. What are some the threats posed by deflation??

Deflation will cause threats to wages and prices. Wages will be cut which will decrease the income of the workers.

2. The expectation of future deflation can have as equally devastating effect. Why is this??

Future deflation can be devastating as well the value of the money will be greater so any investment will be 'profitable'.

3. What evidence does the article put forth that an economy experiencing deflation may eventually “self-correct”, meaning return to the full employment level of output in the long-run??

This is a neoclassical idea. It assures that people will stop spending and start saving money. The businesses will increase output to eventually raise national income.

4. Why don’t governments and central banks just sit back and let the economy self-correct? In other words, why are fiscal and monetary policies being used so aggressively by the US, Great Britain and Switzerland during this economic crisis?

They do not sit back because they want to rise the national income more quickly, instead of leaving the economy follow its own pace.

1. If the deflation is caused by a decrease in aggregate demand, it can cause several threats. First of all, wages as well as prices are under pressure. This is because if aggregate demand falls, companies have to produce less output and therefore need less workers. Workers start competing for jobs, making wages unstable and firms try to underbid each other for their product prices, hoping to make more sales this way, putting the prices under pressure. But also, deflation means that the real debt burdens will rise, causing borrowers to cut spending.

2. If people expect deflation to increase even more, they might expect their salaries to decrease as well. If this happens, people will be spending less, since they have less real money available. They will also borrow less money, since the real debt burden is higher than it used to be before the deflation. This again reduces aggregate demand, which again will reduce salaries and increase unemployment. A vicious cycle…

3. The article suggests that interest rates might help the economy to correct itself. If interest rates are decreased, then people are more likely to invest again as it decreases their real debt burden, i.e. they have to pay less when borrowing money. They make investments, helping the economy to correct itself.

4. I think governments decide to intervene because it would take too long for the economy to self-correct. In that time, other factors might arise, which may weaken plans. Also, as far as I remember from the last blogosphere, the neo-classical way of thinking (of laissez-faire) has shown not to be effective in real life situations and therefore economies decide to interfere to boost the economy.

On your first point: I think you hit a good point there that deflation can lead to unemployment, I just want to expand on why this happens: If deflation is caused by a decrease in aggregate demand, then companies are producing too much. They will therefore reduce production, for which they need less workers, hence unemployment rises.

Your second point: Nice! I had not thought of this before, but it is a good point that if people are expecting prices to fall, they may wait longer and longer, thinking that prices will decrease even further. If I was to buy a new car, then I would also wait longer and longer seeing as the price is reducing and I don't have a huge amount of money to spend, i.e. I could spend it on other things. Well done!

Your third point: I didn't quite understand why firms would eventally save money to hire more workers!? Why would they do so if they only need to produce less anyways?

1)Deflation poses several threats to an economy that is otherwise fundamentally healthy, such as the United States’. What are some the threats posed by deflation?

Deflation puts pressure on wages and prices. If this is caused due to a decrease in the aggregate demand, it will lead to a decrease in most working hours and an increase in unemployment as a whole. Also, the real value of debt burdens will increase, which will mean that borrowers will spend less money, which will further decrease aggregate demand.

2)The expectation of future deflation can have as equally devastating effect. Why is this?

With an expected rise in deflation, people will suppose that their disposable income will decrease dramatically. This belief will cause them to decrease their expenditure, in order to save their resources. In turn, this will decrease the aggregate demand, and the deflation will come to pass. In a way, the anticipation of deflation will lead to actual deflation.

3)What evidence does the article put forth that an economy experiencing deflation may eventually “self-correct”, meaning return to the full employment level of output in the long-run?

This is a Neo-Classical idea, and any Keynesian would disagree. Neo-Classical economists would state that the economy experiencing deflation could in the long run actually "self-correct" for three main reasons. First of all, with a decrease in consumer prices, the aggregate demand will increase, which will cause an increase in employment and thus income. Also, firms will save up their resources, and eventually they will increase their employment, which will increase the supply. This will increase the aggregate demand, and the economy will return to its former level. Lastly, banks are able to manipulate the unterest rates. With banks lowering the interest rates, people would be more willing to spend. This, in turn, will increase the aggregate demand. However, the Keynesians would argue that prices and wages will "stick" at a low level, and the full employment level of output will only be restored with a government intervention in the form of a reflationary policy.

4)Why don’t governments and central banks just sit back and let the economy self-correct? In other words, why are fiscal and monetary policies being used so aggressively by the US, Great Britain and Switzerland during this economic crisis?

In theory, the Neo-Classical method is perfectly reasonable, but in practice it has been proven to not be completely effective. Also, it is unlikely that a government simply has the time to sit and wait for the economy to self correct. Governments, especially those in the US, Great Britain, and Switzerland, need support from the majority of the population. In a situation of a serious recession or of rampant deflation, if the government were to just wait for the economy to self correct they would be replaced. In general, even if the Keynesian method isn't necessarily sound, at least it does something!

You mentioned how it is more beneficial for a government to adopt a Keynesian policy than a Neo-Classical policy because this will create a quicker recovery for the economy. However, it is important to remember that from a Neo-Classical point of view such a policy will only serve to support inflation in the future.

• Deflation poses several threats to an economy that is otherwise fundamentally healthy, such as the United States’. What are some of the threats posed by deflation?

It would have the potential of overusing resources. Since there is a deflationary period, importers from other countries will buy raw materials in such country and lead to other problems such as pollution. There are also another problem of decreasing aggregate demand, which leads to bad growth and creates unemployment.

• The expectation of future deflation can have an equally devastating effect. Why is this?

If a rational consumer knows a certain good will drop its price in a short period of time, it is normal for him to buy the good later. This is the expectation of future deflation effect, which dramatically decrease aggregate demand and leads to bad growth and even worse deflation rate.

• What evidence does the article put forth that an economy experiencing deflation may eventually “self-correct”, meaning return to the full employment level of output in the long-run?

When an economy is in a deflationary period, its currency depreciates. This enables goods to be sold overseas in a more competitive price and export is then increases. This improves the revenue of the country, more production is needed to meet the demand overseas and it will slowly reach full employment

• Why don’t governments and central banks just sit back and let the economy self-correct? In other words, why are fiscal and monetary policies being used so aggressively by the US, Great Britain and Switzerland during this economic crisis?

It is true that the economy is self-correcting. However, there is the factor of time which is also very important. The government tries to avoid this deflationary period and tries to keep it as short as possible so that its citizens’ living standard is retained as soon as possible.

To Ji Yoon:

I agree on what you have suggested. However, although people’s purchasing price decreases, the cost of material also decreases; although the actual price of revenue decreases, the real profit maintained in about the same level. So, do you think that during deflation firms will make less profit?

Threats posed by deflation are if it was caused by a decline in spending in the economy, a decrease in aggregate demand, meaning that households and companies are burdened with debt.

The expectation of future deflation can have a devastating effect because people keep apprised of the financial situation in the world, and if there is deflation occurring, people are likely to save their money. By saving their money, less money is being circulated in the economy, due to lessened consumption by individuals who take advantage of the future implications and expectations.

The article puts forth that an economy experiencing deflation may correct itself by interest rates being lowered, because people may cut their spending to save and invest their money, rather than spending it on material goods. The firms that will gain from the investments can use that increased input to increase their output into the economy to increase the national income.

Governments and central banks don't just sit back and let the economy self-correct because it takes lots of time for the economy to heal itself and go back to normal levels. Through economic policies, governments can help to quickly return their economy to optimum levels of output.

I definitely agree with what you said for all of your answers. I especially liked how you discussed the potential overuse of resources in question one, as I would have never thought of deflation as being able to do that. Your reasoning was very solid, and it made a lot of sense. For question two, in addition to what you said, I thought people would save their money, and not buy the good at all. Either way, there is less money circulating through the economy in a certain period of time. I think what you said for question three made a lot of sense, and it showed how the economy slowly “self-corrects” and builds itself back up again through increases in exports and revenue. For question four, I definitely agree. Time is of the essence, and the government can speed the process of recovery along.

1) Deflation seems like a good thing, because it means that our money becomes more valuable which causes low prices. Companies, however, experience a decrease in their revenues so that they have to lay off workers, as they have to cut costs. If less people are employed, then there are less people with disposable income to spend on goods, and demand drops even further, causing the price level to drop even more. This can cause a vicious cycle.

2) If deflation is expected in the near future then consumers who would normally consume would rather save their money for the rainy day approaching, by doing this they are effectively doing the same as they will have in Question 1, which leads to the same downward spiral.

3) The article states that people will “cut spending” which will mean they will save more. Firms have access to this saving and therefore will this money to increase their stock of capital and their output, which will increase the national income again.

4) Governments don’t wait for the economy to self-correct because this would take a long time, this can only happen in the long run. The huge fiscal stimulus are implemented because people are not willing to accept lower wages at the time. The short run is also called the sticky wages period, meaning that firms cannot decrease wages in such a short time limit. For the economy to self-correct people would have to accept lower income and therefore less spending.

With your answer to number 4, I think its important to further examine the situation before concluding that the economy cannot self-correct. Even if consumer prices are falling due to a decrease in aggregate demand and consumer spending, there is still a chance that the economy can self-correct.

1. Some threats posed by deflation included the loss of jobs due to a decrease in aggregate demand. Also deflation can mean a drop in the disposable income of households causing them to invest less into the economy.

2. An expectation of deflation can have a equally devastating effect because it causes firms to try and prepare for this deflation so they will lay of workers in anticipation. this means even if there is no deflation there are the effects as if there was.

3. This article suggests that an economy may correct itself because of cuts in spending by firms. this means that the prices of goods would decrease and then in turn aggregate demand would increase.

4. Governments don't want to sit back and wait for an economy to correct itself because of how long it would take. This self-correction is a long term effect and who knows how bad the economy would get before being self-corrected.

1) Deflation poses several threats to an economy that is otherwise fundamentally healthy, such as the United States’. What are some of the threats posed by deflation?

With falling prices borrowers will experience an increase in the real value of their debt and in such a climate, companies and individuals with debt may struggle. This in itself may exert a further twist to the downward deflationary spiral. Also, deflation has the side effect of increased unemployment since there is a lower level of demand in the economy, which can lead to an economic depression.

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2) The expectation of future deflation can have an equally devastating effect. Why is this?

Deflation may cause people to postpone their spending in the expectation of even lower prices in the future. When this happens, aggregate demand falls, businesses are unable to sell their goods, make profits or meet their debt repayment obligations, and they may be forced to cut output and employment of workers.

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3) What evidence does the article put forth that an economy experiencing deflation may eventually “self-correct”, meaning return to the full employment level of output in the long-run?

Deflation persisting in the economy depends on the mindset of the public. “So far, expectations of inflation remain stable: that sentiment is itself a welcome bulwark against deflation.”

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4) Why don’t governments and central banks just sit back and let the economy self-correct? In other words, why are fiscal and monetary policies being used so aggressively by the US, Great Britain and Switzerland during this economic crisis?

Declining prices, if they persist, generally create a vicious spiral of negatives such as falling profits, closing factories, shrinking employment and incomes, and increasing defaults on loans by companies and individuals. “…inflation is easier to put right than deflation. A central bank can raise interest rates as high as it wants to suppress inflation, but it cannot cut nominal rates below zero… In the worst case, rising debts and defaults depress growth, poisoning the economy by deepening deflation and pressing real interest rates higher… Given the choice, erring on the side of inflation would be less catastrophic than erring on the side of deflation.”

Alison that is an excellent and very detailed answer for #2. That definitely is a Neo-classical viewpoint, that the economy can correct itself without the help of the government. Great job comparing and contrasting Neo-classical and Keynesian arguments on the issue.

1. Deflation due to a lack of government spending could lead to a rise in unemployment and a fall in AD.

2. This is because consumers will not spend in order to spend later when prices are lower. By anticipating the deflation, the consumers are only speeding its arrival and aggravating the problem.

3. This article does not really present valid evidence that the deflation will eventually self-correct and it actually seems to predict that doom will occur if this problem continues

4. These policies are being used because these governments remember that it was only due to government intervention that they pulled themselves out of the Great Depression. Based on that experience, the best course of action is reflationary policy.

As much as I appreciate your point in question 3, I must stress that even if the deflation is not anticipated, it will probably still occur. The fact that people expected the inflation to continue rising in the USA, they still got into a recession and it surprised the people which actually worsened its effect.

1. Deflation will increase the value of debts, and many companies will find they are unable to repay loans. In addition to that, business may experience low profits as an effect of deferred consumption. As profits fall, business confidence may fall which will cause they to lay off workers, and thus the deflation spiral begins as consumer confidences fall and aggregate demand is further depressed. In the worst case, this could many firms to bankruptcy and consumers to poverty.

2. If consumers expect future deflation, they will want to wait until prices fall further before spending their money. This is called deferred consumption.

3. The article suggests that consumers' mindsets may cause they to believe that inflation is bound to occur in the future, which may actually lead to an increase in AD when price levels fall. This quickly brings AD back up.

4. The governments don't want aggregate demand to fall so slow that the economy becomes heavily disabled like during The Great Depression where consumer's purchasing power was minimal and unemployment was so high. Without government intervention, it might take too long for the economy to 'self-correct'. In the keynesian perspective, an economy in a deep recession will not be able to be saved by market forces alone – the government has to increase spending to kickstart an increase in AD again

1.The deflation will cause effect on unemployment and investment. Because the aggregate demand is low, so the firms might take action to lay off workers. And then consumer confidence and business confidence will be low, and a deflationary spiral occur. Furthermore, deflation will increase the value of debs, and worsen business confidence, and firms are unable to pay loan back.

2.A deferred consumption caused by the consumers expectation. If price is falling, then the consumer will want to wait to spent their money until the price drop even further.

3.The article suggest consumer knows the uncertainty of the future and which aggregate demand will increase again.

4.Because it takes a very long period for the economic to set back and self-correct. Therefore, government wants to intervene so that the aggregate demand can fall rapidly. In Keynesian perspective, government use demand-side policy and so shift the aggregate demand so that increase the consumption and employment rate.

1. When there's a deflation, the aggregare demand is low, causing more unemployments. More people compete for scarce jobs, and the workers' wages would be decrease. People are poorer, but the nominal value of their debts remained, which gives them higher burdens. People with higher debt burden would save their money for repaying the debt, in stead of spending them. Because of low aggregate demand, firms for sure would not take such high risk to invest. Therefore, the aggregate demand remain low, and the deflation boosts, if the situation doesn't change, eventually it may cause a recession. What a vicious spiral!

2. If people expect a future deflation, they may keep their money unit the deflation happen, in order to buy goods in a lower price. During this period, the demand would be low, making prices lower, as well as the quantity supplied, which affects the level of output. Eventually, a deflation really happen.

3. The article suggests that the deflation may "self-correct" if the interest rate keep low. As the interest rate is low, people with spare money would tend to spend more rather than saving them in banks for little interest, and the costs of borrowing money is low, which encourages households and firms to borrow money for fixed assets or investment, and make the aggregate demand increase. So eventually, the economy would slowly stand up in the long run.

4. Because a "self-correct" of economy happens in a long duration of time, in this long period of time, the country's economy would fall behind as others' are growing. Which means the country is "sleeping", and the distance between it and other foreign countries is enlarging. This is not appreciated for any country. So, if a country doesn't want to lag behind in economy, it should make effort to get itself away from recession, as fast as possible.

1) Deflation poses several threats to an economy that is otherwise fundamentally healthy, such as the United States’. What are some the threats posed by deflation?

One of the main threats of having deflation in an economy is that businesses and firms of all kinds will earn less money. By having this problem, other issues may arise as well such as having an increase an unemployment. Since the firms earn less money, this problem may make them become pessimistic about the economy, which then causes them to lower the costs of production. Unfortunately, one of the main methods of lowering the costs of production would be to lay off workers and this would mean that they have to pay less wages, but the level of unemployment in the economy will increase. Other issues of deflation include having a lowering economy and lower economic activity.

2) The expectation of future deflation can have as equally devastating effect. Why is this?

If both firms and consumers are expecting future deflation, then there are two things that may happen. Firms will expect to lay off workers to lower the costs of production, and the consumers will want to save as more money because of the risk of being unemployed and to spend their money in the future when the prices of goods are lowered. This would cause having an increase in the level of withdrawal and less injections to the economy.

3) What evidence does the article put forth that an economy experiencing deflation may eventually “self-correct”, meaning return to the full employment level of output in the long-run?

Although deflation is a situation that governments may have to intervene with, this article brings about evidence that deflation may also eventually self correct itself. This is because if the level of interest rates are lower, consumers theoretically will spend more than save, which would then push the Aggregate Demand positively and hence causing an decrease in the level of unemployment.

4) Why don’t governments and central banks just sit back and let the economy self-correct? In other words, why are fiscal and monetary policies being used so aggressively by the US, Great Britain and Switzerland during this economic crisis?

During an economic crisis, the economic growth of a country will be much slower than normal. This means that the aggregate demand is low and that the level of unemployment is high. Most countries would not choose to let the economy self correct because even though when the prices may lower and the consumer spending may increase, it is still necessary for the economy to have some government spending. This is because the only way to shift the Long Run Aggregate Supply (LRAS) positively is if the government increases its spending. This is shown in the keynesian graph. Fiscal policies deal with having the government spending to increase in its public goods/ merit goods such as healthcare, education, etc. The monetary policy refers to the interest rates, which is controlled mainly by the central bank. By controlling the interest rates, the central banks may be able to push consumers' incentives to spending more or spending less. This is to control the level of inflation.

If the fall in prices is caused by a decline in spending in the economy, that means there will be a decrease in AD. Some threats caused by deflation may include unemployment (more people compete for scarce jobs, result in a low wages). Besides, investors will unlikely to invest in economy due a drop in the disposable income.

If prices are falling, consumers will put off the purchase of any durable goods as they will want to wait until the price drop even further. This may be reffered to as deferred consumption.

This article suggests that an economy experiencing deflation may eventually “self-correct” as a result of cuts in spending by firms, this will in turn increase AD.

This referes to the disavantage of demand side policy. In theory, the time taks for an economic to set back and self-correct is huge, and no one knows how bad the economy would get before it self-correct

The effects that deflation will cause can change the economic states drastically. if deflation happens by increase in AS, in this case it is positive. However, if deflation took place by Demand side, this can be an issue. For example, this will cause increase in unemployment rates and the firms will not tend to invest because they normally have pessimistic ideas towards the future. This lower in investment will gradually affect the economy.

Deflation can have devastating effects on both firms and consumers. first of all, as i mentioned before, there will be more unemployment because firms tend to have lower wages than before. this means that household has more possibility to lose jobs. Secondly, firms will not earn as much as they used to because of deflation. as they earn less, they may lose their confidence in business and this will cause firms not to invest.

Even though there is a deflation take place, economy will self-correct because in economy, when something changes, there are other responsiveness. in this case, deflation will differ the AS and AD curve. however there are other factors that can change the AS and AD. Thus these AS and AD curves will come back to be stable again.

This is because there is a lot of time consuming for economy to be stable again without government intervention. with government intervention, the economy can come back to the stable point rapidly.